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Time Warner Inc. (NYSE:TWX)

Q3 2006 Earnings Call

November 1, 2006 8:30 am ET

Executives

Dick Parsons – Chairman, CEO

Jeff Bewkes – President, COO

Wayne Pace - CFO

James Burtson - SVP, IR

Analysts

Spencer Wang - Bear Stearns

Michael Nathanson - Sanford Bernstein

Doug Mitchelson - Deutsche Bank

Jessica Reif Cohen - Merrill Lynch

William Drewry - Credit Suisse

Anthony Noto - Goldman Sachs

Lowell Singer - Cowen & Co

Vijay Jayant - Lehman Brothers

Richard Greenfield - Pail Research

Gordon Hodge - Thomas Weisel Partners

Presentation

Operator

Welcome to Time Warner's third quarter 2006 earnings call. (Operator Instructions) I will turn the conference call over to Mr. James Burtson, Senior Vice President of Investor Relations for Time Warner.

James Burtson

Thanks, operator and good morning, everyone. Welcome to Time Warner's 2006 third quarter earnings conference call. Joining me this morning are Time Warner's Chairman and CEO Dick Parsons; President and COO Jeff Bewkes; and Chief Financial Officer Wayne Pace.

This morning we issued two press releases, the first detailing our third quarter results and the second reaffirming our 2006 full year business outlook. Before we begin, there are a number of items I need to cover with you.

First, we refer to non-GAAP measures, including operating income before depreciation and amortization, or OIBDA, and free cash flow. We use these measures when we analyze year-over-year comparisons. In order to enhance comparability, we eliminate certain items such as non-cash asset impairments, gains or losses from asset disposals and amounts related to securities litigation and government investigations. We call this measure adjusted operating income before depreciation and amortization or adjusted OIBDA. Schedules setting our reconciliations of these historical non-GAAP financial measures to operating income and cash provided by operations or the other most directly comparable GAAP financial measures are included in our trending schedules. These reconciliations are available in today's earnings release and on our Company's website at www.TimeWarner.com/investors. A reconciliation of our expected future financial performance is also included in the business outlook release that is now available on our website.

Second, at the top of our earnings announcement, you will see a preamble that sets out a description of the basis of presentation for Time Warner's historical financial results described in the release. Specifically Time Warner's historical results reflect, among other items, the discontinued operations treatment of certain cable systems transferred to Comcast Corporation related to the redemption of Comcast's interests in Time Warner Cable and Time Warner Entertainment Company LP, and the exchange of cable systems with Comcast.

In addition, the results for the three months ended September 30, 2006 include the impact of certain cable systems acquired from Adelphia Communications Corporation and Comcast since the closing of the transactions on July 31, 2006. As such, the homes passed and subscriber information in our trending schedules have been updated for each of these transactions. For the third quarter, our results include the systems acquired from Adelphia and Comcast from the date of closing. For periods prior to the third quarter, the amounts reflect the historical Time Warner Cable systems, excluding the systems transferred to Comcast, as well as the Houston system, which Comcast will receive as part of the dissolution of our Texas/Kansas City cable partnership.

Also, for the third quarter, additional disclosure has been included in the notes to our earnings release that provides subscriber results for historical Time Warner Cable systems, as well as the acquired systems.

Third, today's announcement includes certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations or beliefs and are subject to uncertainty and changes in circumstances. Actual results may vary materially from those expressed or implied by the statements herein due to changes in economic, business, competitive, technological and/or regulatory factors. More detailed information about these factors may be found in Time Warner's SEC filings, including its most recent annual report on Form 10-K as amended and its quarterly reports on Form 10-Q as amended. Time Warner is under no obligation and, in fact, expressly disclaims any such obligation to update or alter its forward-looking statements whether as a result of new information, future events or otherwise.

With that covered, I will thank you and turn the call over to Dick.

Dick Parsons

Thanks, Jim and good morning, ladies and gentlemen. We appreciate you joining us on the call today. As you can tell from Jim's intro, we have got a lot to cover on this call this morning, particularly with the inclusion of the Adelphia/Comcast transactions in our numbers, there is a lot going on in this quarter. So before diving into the details, let me set out for you the three headlines from the quarter as I see them.

First, we are encouraged by the early progress AOL is making in its transition to an advertising-supported business. AOL members are indeed converting to free. We are on track to grow usage, and our monetization continues to improve.

Second, Time Warner Cable is generating outstanding results, even as it successfully integrates its new systems from Adelphia and Comcast. The triple play bundle continues to drive revenues up and churn down, and the addition to our footprint of what amounts to virgin territory for phone promises to accelerate our growth going forward.

Third, our capital allocation initiatives are delivering value to our shareholders. In particular, our share repurchase program has proven to be highly efficient, but more on that in a moment. Let me now turn to the quarter's performance.

I'm pleased to say Time Warner delivered strong results for the quarter. Adjusted operating income before depreciation and amortization, or as Jim mentioned adjusted OIBDA, grew 16%, including the impact of the cable systems acquired from Adelphia and Comcast. We again generated impressive free cash flow, converting 50% or $4 billion of our adjusted OIBDA to free cash through the first nine months of this year. In fact, we are on pace to deliver around $1.00 per share free cash flow for the full year.

Our adjusted diluted earnings per share in the quarter was $0.19, up 12% from the prior year. We achieved this growth despite the dilutive impact on EPS of the Adelphia and Comcast transactions.

As you saw in this morning's business outlook press release, we are reaffirming our full year guidance of low double-digit adjusted OIBDA growth. Additionally, we continue to expect to convert 35% to 45% of our adjusted OIBDA to free cash flow.

Looking briefly at the individual performances of our segments, the results at our film entertainment, networks and publishing segments were all strong enough to keep us on track to beat our outlook for those divisions for the full year. Wayne will have more to say about that in a moment.

Time Warner Cable delivered another great quarter. Our historical Time Warner Cable systems performed extremely well across all key segments. Most notably, revenue in historical systems grew 15%. Also, in historical systems our basic, digital and high-speed data subscriber net additions were all up compared to a year ago. In fact, high-speed data net additions were in excess of 200,000 for the fifth quarter in a row, and digital phone continued to make strong gains in penetration, now at 11% of all eligible homes.

With Time Warner Cable's continued excellent performance in its historical systems, we are focused sharply on successfully integrating our newly acquired systems. So far, this process is going very well, and we are on plan. After only a couple of months, Time Warner Cable has already begun the infrastructure upgrades.

Looking out into the next year, our priorities at Time Warner Cable, beyond integrating our new systems, start with continuing to drive the triple play bundle. Triple play penetration reached 9% of all customers in the third quarter. While we're pleased so far, there is significant opportunity to improve on this success, particularly when you consider that we have yet to introduce phone into the old Adelphia systems.

Additionally, Time Warner Cable will continue to innovate for future growth, including further developing an interactive video advertising business and beginning to roll out commercial voice and scale.

With respect to AOL, the early results of the strategy we announced last summer are encouraging. We are converting a significant number of AOL subscribers to free on broadband, and importantly, these members are maintaining their level of usage after they switch. In addition, we are also signing up more new users than we initially expected. Not only are former AOL subscribers coming back, a host of new first-time users are signing up. This progress is reinforcing our confidence that AOL is on track to start growing usage, meaning page views, next year. Fundamentally this is exactly what we were trying to accomplish.

This is especially encouraging because AOL continues to monetize its volumes very effectively. In the third quarter, AOL's advertising revenue grew a stellar 46%. For the second quarter in a row, we believe that AOL has gained share domestically, and as we look into next year, we continue to believe that AOL will grow at least in line with the domestic online advertising market.

Now before I ask Wayne for his normal detailed review of the quarterly results, let me update you on our capital allocations activities. I will start with our divestitures for non-core assets. Since the beginning of this year, we have announced or closed on the following list of divestitures: Time Warner Book Group, Turner South Network, our half of the Warner theme parks in Australia, our holdings in Time Warner Telecom, and AOL's Internet access businesses in France, Germany and the UK. In total, these transactions represent over $4 billion in net proceeds for Time Warner. By contrast, they represented only a little more than about $100 million in reductions in the Company's operating earnings.

Now lest anyone think that we are merely selling off assets, we have also expended over $20 billion on acquisitions in this year. That includes more than $14 billion to acquire the Adelphia and Comcast Cable systems, $5 billion to redeem Comcast's 21% ownership in Time Warner Cable, and about $700 million to purchase the 50% of Court TV we did not own.

We have also returned significant capital directly to our shareholders. So far this year, we have made over $650 million in dividend payments, and to date we have repurchased approximately $13.5 billion of our stock. In total, we bought back over 16% of our outstanding shares since we began the share repurchase program last year at an average price of $17.44 per share. We remain on track to complete at least $15 billion of our announced $20 billion program by the end of this year.

We believe that these capital allocation initiatives have created value for shareholders and have every confidence that we will stay aggressive, not only on the operating front but in smartly deploying our financial capacity in the year ahead.

Now with that, I thank you again, and I will turn it over to Wayne.

Wayne Pace

Thank you, Dick, and good morning, everyone. As usual, the slides that I will refer to this morning are now available for you on our website. We will begin with an overview of our third quarter consolidated results, which you can see here on this first slide. Revenues increased 7% over the prior year quarter to $10.9 billion. Adjusted OIBDA grew 16% to $2.9 billion, and our third quarter margin increased approximately 200 basis points to 26%. These results included the impact of the Adelphia and Comcast transactions which closed on July 31. The cable systems we acquired have been accounted for as of the closing date, while the systems we transferred to Comcast, related primarily to the redemption of their interests in Time Warner Cable and Time Warner Entertainment, have been accounted for as discontinued operations for all periods presented.

Looking at earnings per share, diluted EPS before discontinued operations was $0.33 in the quarter. Included in this current quarter are $729 million in pretax investment gains related primarily to the sales of our interests in the Time Warner Telecom and Warner Brothers Australian theme parks. In addition, our third quarter earnings included a tax benefit related to the recognition of net capital loss carryforwards and an impairment charge to reduce the carrying value of goodwill related to the WB Network. These and certain other items are detailed in our press release and our trending schedules for you.

The net impact of these items increased EPS by $0.14 in the 2006 quarter. Without these items, EPS grew 12%, as Dick mentioned, reflecting higher adjusted OIBDA and lower share count, offset in part by the expected impact of higher levels of depreciation and amortization and interest expense due to the Adelphia and Comcast transactions.

Moving to free cash flow, through the first nine months we generated $4 billion in free cash flow and converted a very healthy 50% of our adjusted OIBDA into free cash. This slide here shows the usual detail that we give you each quarter.

Moving to net debt, we ended the third quarter with net debt of just over $32 billion, an increase of approximately $16 billion from the end of last year and $10 billion since June 30. As you can see on this slide, a large portion of the increase -- about $11 billion -- is related to the Adelphia and Comcast transactions, and about $11 billion is related to our share repurchase program. These items were offset in part by the free cash flow we have generated so far this year, as well as the investment proceeds, including the sale of our stake in Time Warner Telecom of about $800 million.

Also, during the third quarter, Time Warner Cable paid a deposit of $182 million related to its $632 million investment in the wireless spectrum joint venture. The remaining $450 million has been funded in our current fourth quarter. In addition, we received $630 million in cash from Comcast in early October as part of the debt refinancing for the Texas/Kansas City cable partnership. We expect to complete the dissolution of the partnership as early as the end of this year, at which time we will begin to consolidate the operations of the Kansas City, the South and West Texas and New Mexico systems. The other systems, as you know and as Jim mentioned, go to Comcast.

As consideration for the sale of AOL's Internet access business in France, which by the way closed yesterday, we received proceeds of about $365 million. That money is in the bank. We hope to close the UK sale by the end of the year and Germany by early next year.

Lastly, I want to say that we are quite comfortable with how we are managing Time Warner's balance sheet. We have adhered to the parameters that we laid out for you a year ago, and we remain committed to managing a strong, healthy balance sheet going forward.

This next slide highlights the progress of our share repurchase program, which Dick has updated you on earlier. Dick also took you through our business outlook, so I won't spend much time here. I would like to remind you, though, that all of our outlook numbers include the impact of the Adelphia and Comcast transactions.

With that, we would like to spend the next few minutes on the results of each of our segments, and then we will go to Q&A.

We will start first with cable. As Dick mentioned, we had another very strong quarterly performance. Revenues increased 44% year over year, which included 15% growth in the historical Time Warner Cable systems. Subscription revenue benefited from the acquired systems as well as the continued growth of high-speed data, digital phone and advanced digital video services.

Average total monthly revenue per basic subscriber or ARPU increased 9% from the prior year to nearly $95. In the historical systems, ARPU grew a robust 13% to $98. Additionally, ARPU in the acquired systems was $82, which highlights the opportunity that we see in these systems.

OIBDA increased 28%, once again benefiting from the Adelphia and Comcast transactions and the growth in advanced services. Our margin for the quarter declined approximately 400 basis points to 35%. As expected, this change was due mostly to the addition of the acquired systems. Our results also include $22 million in merger-related and restructuring charges, as well as the impact of foregone management fees associated with the pending dissolution of the Texas/Kansas City cable partnership.

For more detail on all of this, please refer to our 10-Q which was filed earlier today, and as always, please give us a call if you have questions.

In addition, as Dick mentioned, we are investing across our operations to ensure the successful integration of the acquired systems. Increased expenses include new marketing programs and the hiring and training of additional CSRs. These are good things which will benefit our operations going forward.

Moving to subscribers, hopefully you have had a chance to see the additional disclosure we provided with the earnings release, which shows subscriber information for the acquired systems as well as the historical systems. The performance of the historical systems remain very strong. Overall in the third quarter, we added 570,000 net revenue generating units or RGUs. This comprises 583,000 from the historical systems and a decrease of 13,000 in the acquired systems.

Basic video subscribers increased 3,000 including a loss of 30,000 in the acquired systems. The historical systems rose 33,000 compared to the proceeding quarter, representing year-over-year growth in basic customers of 1.4%. This was the fifth consecutive quarter of basic subscriber growth in these historical systems. We added a net 136,000 digital video customers, bringing digital video customers to 7 million or 52% penetration of basic subscribers. Digital net adds in the historical systems were 143,000 up 4% from the prior quarter, while the acquired systems declined 7,000. In addition, we ended the quarter with 2.2 million DVR customers, which represented 31% of our digital customers.

Residential high-speed data subscribers increased 251,000. That includes 214,000 in the historical systems, and that represents the fifth consecutive quarter of more than 200,000 net additions. In total, we now have 6.4 million data customers or 25% penetration of eligible homes.

Lastly, we continue to be pleased with our progress with digital phone. We added 187,000 digital phone subscribers in the quarter, bringing penetration of service-ready homes to 11%. The increase in net adds was related solely to the historical systems as digital phone is not yet offered in the acquired systems. As we look out, we see plenty of digital phone growth ahead of us, particularly as we roll out the service in the acquired systems. To put our optimism in perspective, we already have four divisions where penetration is now at least 20%.

Looking at film, revenues were down 10%, due mostly to lower revenues from theatrical products as compared to the prior year quarter. Please remember that last year included results from Warner Brothers’ Charlie and the Chocolate Factory and Batman Begins, as well as New Line's Wedding Crashers. This year's quarter included revenue from the strong worldwide theatrical performance of Batman Returns.

OIBDA decreased 14%, due primarily to the decline in revenues and offset somewhat by higher contributions from television product, as well as a benefit of approximately $10 million related to a reduction in certain legal reserves.

Moving to networks, revenues grew 4%. This was led by higher subscription and advertising revenues, including $60 million from the consolidation of Court TV, and was offset partly by lower content revenue at HBO, and that was due to higher syndication revenues from Sex and the City in the prior year quarter.

Subscription revenue increased 9% benefiting from higher rates and subscribers at Turner and at HBO, as well as $17 million from inclusion of Court TV. Ad revenue growth of 6% was driven by a 16% gain at Turner, which included $42 million or 7 percentage points of this growth from Court TV. That was offset in part by a 36% decline at the WB Network, which was related to lower primetime ratings and also the fact that the operations closed on September 17 of this year.

As a reminder, we are equity accounting from that date to our 50% interest in this CW Network going forward, so the results will no longer be included in the network segment but as a component of the other income line on our income statement below our reported consolidated OIBDA.

Adjusted OIBDA increased 9%, due largely to the increase in revenues, as well as lower marketing expenses. These items were offset partially by higher programming expenses related to Court TV and $38 million in shutdown costs at The WB.

One last note on networks. HBO has finalized its agreement with A&E for syndication of The Sopranos, under which it now expects to receive revenues for the first five seasons during the fourth quarter of this year.

Now moving on to AOL. Revenue declined 3%, due mostly to a 13% decline in subscription revenues which reflected continued subscriber losses. The decrease was offset in part by a 46% increase in advertising revenues, which benefited from solid growth across advertising run on third-party websites generated by Advertising.com, as well as display and paid search advertising. OIBDA rose 21% as lower costs and higher advertising revenues more than offset the impact from lower subscription revenues.

As we have previously communicated with you, we began to significantly reduce subscriber acquisition marketing during the third quarter. In fact, total marketing expenses declined $177 million compared to the prior year quarter. Our third quarter results also included $27 million of restructuring charges associated with AOL's strategic changes. We do expect to incur between $150 million and $240 million of additional restructuring charges during the fourth quarter.

This next slide highlights AOL's audience metrics for the third quarter. Domestic ad revenues less traffic acquisition costs, or TAC, of $304 million increased 3% sequentially from the second quarter. Third quarter unduplicated monthly domestic unique visitors averaged 112 million. Compared to the second quarter, total domestic page views declined 6% to about 49 billion, and domestic ad revenue, less TAC per 1,000 page views, increased 9% to $6.24.

Moving to AOL's membership base. In the third quarter, domestic AOL members declined by 2.5 million to 15.2 million. Monthly ARPU of $19.30 decreased slightly compared to the second quarter, but grew modestly over the third quarter of last year. The decline in domestic AOL members this quarter was higher compared to the second quarter for two main reasons, both of which are related to the strategy changes AOL announced on August 2.

First, 1.5 million members migrated to the free service, including approximately 400,000 subscribers associated with an agreement between AOL and Time Warner Cable. Second, there were around 350,000 fewer registrations in the third quarter, which reflected the lower acquisition marketing expenditures under the new strategy I mentioned a moment ago.

Lastly let me comment on publishing. Revenues increased 1% compared to the prior year. Advertising revenues grew 5%. This was led by higher online revenues, as well as gains at international magazines primarily from the acquisition of Grupo Editorial Expansion, which was completed in August 2005. Also contributing to the growth were gains at People and Real Simple. OIBDA increased 3% with gains at certain international and domestic magazines, as well as lower magazine start-up losses.

With that, we will go back to Jim to start the Q&A part of our call.

James Burtson

Thanks, Wayne. Operator, we are ready when you are.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Spencer Wang - Bear Stearns.

Spencer Wang - Bear Stearns

Thanks and good morning. Just one quick question on cable. The voice net adds, I think it decelerated for the second quarter in a row. Can you just talk about what is driving that and if you have launched the in-state calling plan within the quarter, and how that impacted the sub growth? If you could just talk about the competitive response you're seeing from the incumbent telephone companies, that would be great. Thanks.

Jeff Bewkes

Hi Spencer. As I think you all know, we are very happy with our success in phone so far over the last year or more, and we're ahead of the industry with 11% of eligible homes on VoIP. But of course, the next 10 points of penetration above 11% that we are at now are harder than the first 10 or 11 points.

To your question, we have also seen some more aggressive marketing activity from the telcos, particularly in our case in the Carolinas. That was expected, and we are at this point lifting our performance there as well. So you definitely ask yourself, have we had a ceiling? No, it is very clear to us that we haven’t. We have got several systems already over 20%: Albany, Syracuse, Binghamton, all heading towards 25%. With offerings like the $99 triple play bundle which we introduced in every division in September, we don't see why we can’t get there and keep moving up across our footprint. And, as Dick said, we have not yet put it into our Adelphia and Comcast systems, or mostly our Adelphia systems. We have really high hopes for pretty rapid progress there as we integrate those.

Spencer Wang - Bear Stearns

Thank you.

Operator

Your next question comes from Michael Nathanson - Sanford Bernstein.

Michael Nathanson - Sanford Bernstein

I want to go back to that cable question for a second. The question we have is one of comparability. It looks like VoIP and HSD adds in the existing Time Warner footprint are little bit lighter than we thought. But I wonder if you can contrast the VoIP penetration in the systems you gave to Comcast versus the penetration in the systems you got from Comcast for VoIP and for HSD? Is it a comparison issue?

Dick Parsons

You are saying the penetration in which areas?

Michael Nathanson - Sanford Bernstein

Basically if you look at the swaps you just went through with Comcast, you swapped some systems, we wanted to know what the VoIP and HSD penetration was in the systems you swapped versus what you got back from Comcast?

Jeff Bewkes

One thing I do know right off the top of my head, the earnings margin in terms of the systems we transferred to Comcast, some of the systems we transferred had margins as high as in the 40% range, whereas the systems that we acquired from Comcast had margins under 30%; coupled with the subs we acquired from Adelphia, which were lower than that, we basically got 4 million new subs at margins below our average.

Now that is really good news in terms of upside, which we will have not much difficulty bringing in. That is what we do. But the reason for those margins has a lot to do with the lack of penetration in advanced services in either Adelphia or Comcast. Remember, if you just look at the basic stats for Time Warner Cable, and this is now going back to the historical part, we are the leading MSO, as I think you all know, in the deployment of every advanced service. So we have the highest penetration of digital video, high-speed data, digital phone, and we think we can extend that in Adelphia.

We obviously need to also improve the performance of those advanced services in the Comcast systems that we got. So they are coming from a lower base. Just to give you a few numbers, our basic penetration at 52% of homes, digital penetration at 52% of basic, which Comcast I don't think is at that level which reflects what happens when you take in some of their systems. High-speed data, we are at 25% of eligible households, and phone, as we said, we are at 11%.

So because we have higher penetration whenever we pick up systems, in this case from Adelphia/Comcast, they are going to come in at somewhat lower performance rates, and that is part of the reason we did this acquisition.

Michael Nathanson - Sanford Bernstein

Right. I guess my question to almost help your explaining this is to show what the net impact was on a sub basis for advanced services. Because I think people look at the number and say, well, it is a bit lighter than we thought.

Jeff Bewkes

I see what you are saying. For example digital, I think you have a blended number of 136. We were up 143 in historical digital subs which is up over what we did last year. High-speed data we had 250 total, 215 in historical systems. Phone, I don't have the phone because they don't really have it. It is all us. I don't know if that answers your question.

Michael Nathanson - Sanford Bernstein

Well, I will tell you what. I will go to Jim, and then I will come back.

Wayne Pace

Mike, I am happy to take you through the detail between them. Because I think underneath, if that is what you're trying to get at is, what were the relative penetrations before and after? With the trending schedules, we can take you through that. The important thing there, particularly on phone, is we are not looking out and seeing a real deceleration of net adds in front of us.

Dick Parsons

Absolutely.

Operator

Your next question comes from Doug Mitchelson - Deutsche Bank.

Doug Mitchelson - Deutsche Bank

Thank you very much. Not to beat a dead horse here on the phone side, but you mentioned the next 10 points would be more difficult than the last 10 points. Given the financial dynamics surrounding phone have come in much more favorably than anyone expected a few years ago, have you considered moving to a more aggressive promotional price posture at some point, next year or the year following? $79 or $89 a month offer sort of thing?

Jeff Bewkes

Remember, we just started the $99 bundle. We have some other offerings we are putting in, in phone. If it turns out you need to do things like that, which is by no means clear at this point, we have a very superior performance and priced product as it is. I think that is not just true of Time Warner phone, but it is true of cable industry phone. There are some dimensions to that that is going to keep the consumer phone business moving well throughout the cable industry.

So we say it is a little harder. It is just obvious that it is easier to get the first 10 points than the next 10 points. We don't see a problem with it. We have done it in other systems, and we have got, as we have said, we're repeating ourselves, but we have got a lot of phone territory that we just picked up that is going to be the easy first 10 points.

Doug Mitchelson - Deutsche Bank

Great, thanks.

Operator

Your next question comes from Jessica Reif Cohen - Merrill Lynch.

Jessica Reif Cohen - Merrill Lynch

Thanks. I will switch gears at this point and just ask a couple of quick questions. Can you comment on the cable networks go to market for the fourth quarter? Can you comment on the magazine sales, what the interest level is and the timing? And then finally, you said that you expect AOL advertising to grow next year in line with the market. Can you quantify the range you expect the market to grow?

Jeff Bewkes

Let me go in the order you asked. The scatter market is good and picking up in terms of being higher. Let's say it is about mid to high single-digits above the -- call it mid single-digits -- above the upfront market. As you remember, at Turner we did better in the upfront, when we were basically the lead price and ad revenue performer in the upfront against all the other cable networks.

As we said in this release, Turner's ad revenue is up 9% without Court TV, 16% with. So we think we are going to low to mid single-digit price increases over the upfront to finish the scatter market. So that was your network question.

Dick Parsons

On magazines, Jessica, yes, there is an awful lot of interest, actually. I think the initial indication was from over 70 different potential buyers. We are second round now, and we are down to somewhere in the eight to ten. There is plenty of interest, but it is too early to call how the game is going to end. But we're confident that we will have a successful transaction there.

Your last one I guess was on what we expect ad growth to be in the online space next year, right?

Jessica Reif Cohen - Merrill Lynch

Right.

Dick Parsons

The reason we articulate it the way we articulate it and said that we will be at least on the market is I have seen estimates all over the place anywhere from high-teens to the mid-30s. I think it is going to be robust, and I think we have taken domestic share, at least, in the last two quarters. We see at the rate that AOL is monetizing these eyeballs, with usage starting to grow, we don't see any abatement on that front. So whatever it turns out to be within that range, I think we will be on it or above it.

Jeff Bewkes

Let me add to it and give some context for AOL. Because as Wayne and Dick reported, the ad revenues were up 46% year over year. We were up 6% sequentially after a 40% ad growth and revenue gain in the second quarter. It is important to look at some of the pieces of that. Monetization is part of this, and our revenue per thousand grew 60% year-over-year to $6.24, it was up from $3.85 last year, and it puts us solidly in the ranks of our two closest competitors.

Put the ad revenue in the context of the total AOL plan. As we said on August 2, we were very happy and encouraged with what is happening. Our main goal is to maximize users for AOL, whether they are registered free users or whether they are paying subs, and then we want to increase their engagement, which is obviously what we monetize. We have turned this around since the August 2 changeover, and we're on track to grow both total users and page views next year in 2007.

To do this, as we have said, we have really three basic legs to the strategy. One is to reshape the access business by making AOL free to anyone with broadband. The second is to drive engagement and monetization. The third is to reduce costs. So, at the end of the third quarter, we had about 3 million free AOL e-mail accounts. Two-thirds of these came from converted members who, before we made this change, they used to leave the service and they used to leave the ad base. But that also means we added 1 million new free users, over 1 million new free users that were not with us two months ago.

Our unique visitors were stable at 113 million, which is a very important part obviously. It is the foundation of the advertising business. The big news for us is that the page views decline in this quarter was only 5%. If you take out the fact that we moved our Time publishing titles out of the AOL, we only had a page view decline of 3%, and we started this change a month into the quarter. So what we are looking at here is page views turning around and starting to grow pretty soon.

On the cost side, which is the last part, we're on track solidly. It is a lot of work going into this to cut at least $1 billion by the end of '07. At the rate we're going, we will do considerably better than that. So between all those points those are the things that underpin the ad growth rates, and we're having growth in advertising, Jessica, from all the product categories. We had Ad.com, our third-party business, grew 95%. Our display ads grew 39%, and search grew 27%. The more people we have using this service and the more engagement in page views that we have per user -- because our usage is holding up as people move over to free, which is another big part of the success of this -- that will also and does drive search activity and revenue.

Finally, we are in partnership with Google on search. So when we take our traffic and put it into that search category, it performs extremely well.

Wayne Pace

The last thing, Jessica, I would add to that, I think it is fair to say although we are not going to give specific estimates for next year, it is fair to say we are not counting on the kind of growth that we have been delivering for the last couple of quarters. We would be happy to have it, but we are not counting on it.

Operator

Your next question comes from William Drewry - Credit Suisse.

William Drewry - Credit Suisse

Thank you. I just wanted to stick with AOL for a couple of questions. I was just wondering, Jeff, does each division now have its own separate Internet strategy? You had an announcement out of Turner today. They seem to be pursuing a lot of things, and now this new deluxe network. I was just wondering how each of the divisions are working with AOL at this point going forward?

Also, I just wondered if you could quantify the marketing cost opportunity capture for next year?

And then just one other thing. I guess Jonathan Miller had some comments last week that put speculation into the market about the future of AOL. I was just wondering, is there any reason why AOL, given this great success that you're having right now, is not a core asset for the company going forward? Thanks.

Jeff Bewkes

Well, AOL is definitely a core asset for the company and growing really well. On your digital question across the different businesses that Time Warner is in, Time Warner is the leading industry participant in five different industries: film, networks, publishing, cable, et cetera. Each of those industries has obvious online or digital strategies. We have them in each of our companies as we would if they were standing on their own

But having said that, there is tremendous advantages of some of the things that we can do together. As for AOL, there are numerous products, for example, into TV with Warner Brothers, the combination of TMZ and People celebrity sites, which are the leading celebrity sites on AOL. There are so many; it is hard to remember. There is also, of course, things like the CNNMoney/Fortune cooperation between our publishing company and our Turner/CNN business, which is already the fourth-largest finance site. There are joint ventures underway with HBO and AOL in comedy.

There are just a tremendous number of ways that if you look at it say, from my position, where we look at essentially a common set of metrics across our different businesses. If you go through from publishing to networks into AOL, all of them need to focus on unique visitors and driving traffic.

We have terrific leadership, say, in our print leadership branch. Just to use one, let's say, People. It has got about 40 million readers in print. We've got over 5 million uniques already on the People.com site, 250 million page views a month so it is the leading celebrity cite online. Sports Illustrated is 450 million page views a month.

Basically when we get together, we look at all these businesses from HBO to CNN to People on both the previous distribution method, which is either the printed page or the television screen, and increasingly the new distribution method, which is a broadband PC screen or a mobile device screen, and the things that we learn in one division, we can apply in another.

Dick Parsons

Bill, you know, your question is a good one in that it does point to something that I would say has a subtle but significant difference in the way we are thinking about the interrelationship with all these businesses and assets. As Jeff has just indicated, each of our operating divisions has to have its own Internet strategy, its own strategy for moving its brands or its businesses onto the web. AOL can be sometimes a partner in that and sometimes offer some assistance in terms of insights into that. But each of these businesses has to have its own strategy for how it is going to meld the digital opportunities the technologies present.

Now in terms of AOL being a core asset, when you think about what we're trying to do with that asset, which Jeff was explaining to Jessica in some earlier questions, we're trying to make it a more robust audience/advertising platform. Because as we see from our other businesses in fact, advertisers are moving online, advertising dollars are shifting online. What do we in our combination of businesses here in Time Warner? We have content revenues. That is one revenue driver. We've got subscription revenues. That is one revenue driver. We have got advertising revenues.

But we want to be in that game, in the online game, and where we can do it more robustly is AOL. So AOL is a core asset of our portfolio because it is in one of the three big revenue driving streams that we fish in. As Jeff said, we're very pleased with what is going on in terms of the new strategy.

So I am not 100% sure exactly what musings that Jon Miller, who is doing a terrific job in terms of moving us to the strategy you were talking about, but it is a core asset, and I think we have got it on the right track.

Jeff Bewkes

I thought -- Jon was over in Europe, and we just did the AOL Europe deals where we moved out of access and increased our footprint in audience and advertising. I think in response to questions if you are in Europe how does this apply to the United States? We would all say that we always evaluate any alternatives that are more profitable in the long run. The long run is key to making that assessment.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. As I analyze the different drivers of advertising at AOL, the AOL business for advertising, excluding Ad.com, looks like it is up 33%. When I peel through the advertising growth that has been driven by RPM growth versus page view declines, it basically looks as we go into 2007 that you need to have 15% to 20% RPM growth again, with low single-digit page view growth in order to get to what we have for industry growth in online advertising.

So my question, Jeff, specifically is, do you think you can get mid-teens to 20% growth in RPM again in 2007? And if not, what would you be assuming on the page view growth side to get to the industry growth rate? Thanks.

Jeff Bewkes

You know, let's go to the page views. As we said, the decline is now down to 3% if you factor out moving our own titles out of Time Inc. That is in the first two months of a change where out of the three months of the quarter, one of them we were under the old method. What that means to me, if you look of the last two or three years, page views have been declining there because of the loss of paying subs in the 15% a year or more range. That is over with. So that means page views won't be declining for that reason.

We think users will go up if you look at paying plus free registered users, and as we have said, that means the page views are going to increase. I'm not going to give a specific mix of what we're going to do with page views versus what we're going to do with RPMs. I'm not sure if I'm allowed to give specific guidance on ad growth rates in relation to the industry.

Inherent in your question is, we feel very good about how we are going to do in ad revenue growth in relation to industry ad revenue growth in online. That will come from a combination of the two things you mentioned. Just to finish, I don't think it is unreasonable for us to do RPM growth in the neighborhood of what you asked about.

Anthony Noto - Goldman Sachs

Do you also consider any risk to companies like Yahoo! that are only selling 50% of their page views, basically flooding the market with a lot of second-tier inventory through processes similar to Advertising.com through their investment in Right Media, and could there be any risk of deflation in pricing as it relates to the inventory that you're really selling at a much higher rate today?

Jeff Bewkes

Are you asking whether our competition is flooding the market with not so good inventory?

Anthony Noto - Goldman Sachs

Up until this point, Yahoo! has only been selling about 50% of its page views, and they are finding it more and more challenging to compete with the methodologies of selling through companies like Advertising.com and other competitors. And so they have made a strategic shift to try to sell a much greater percentage of their page views that previously they had not sold because it would have diluted their pricing on their premium product.

So, as they start to try to sell through 70% to 75% of their page views instead of 50%, there is going to be a lot of other available inventory at much, much more competitive pricing than we have seen in the past. Is that a factor that is weighed into your outlook for 2007?

Jeff Bewkes

Yes, we are not worried about that. Two advantages. One is what I was trying to explain, which is engagement. As we said when we shifted over on August 2, we have a user base at AOL that has the strongest, the longest session online, the most page views on the web. We have got an extremely engaged user base, and we see that holding up as they move over to free registered user status. Combining that with our capability at Ad.com and in other parts of AOL and video advertising, to monetize not just our own inventory but everybody else's, we are actually, I think, increasing our competitive position in that field. So those trends you cite are good for us.

James Burtson

The one thing I would add to that is that in your analysis, what is different for us I think or I don't want to say it is confusing, but page views and usable inventory are not necessarily the same thing. So, as you are aware, we have actually been growing our available inventory through the year with the inclusion of the client email, which is obviously a big category online, a premium category in terms of pricing. So I think we see pretty good headroom in front of us in terms of our ability in the mix to have good increases for RPMs, whether it is from both volume and inventory mix.

Anthony Noto - Goldman Sachs

Thank you.

Operator

Your next question comes from Lowell Singer - Cowen & Co.

Lowell Singer - Cowen & Co

Jeff, I wanted to ask you a question about film entertainment. Are you highly confident that you can grow the bottom line at that business next year? Can you lay out for us the key things that need to happen both along the theatrical release side and also the syndication and home video side for you guys to return to growth there next year?

Jeff Bewkes

I am highly confident that we will grow the earnings in the film side next year. We have always said it, but it is worth emphasizing. We had a hell of a year in '05. It was a record year in theatrical. We were number one domestic and worldwide, home video, television, everything. So the film business moves around a little bit, and looking just at this next couple of months in '06, we have got essentially the top of our line upcoming at the late release schedule between The Departed, which is doing very well; Happy Feet is going to be a big film; Blood Diamond is going to be a big film. But they are all coming at the end of the year, which means the theatrical revenue, a good piece of it and all of the video revenue, flows into 2007. That is very auspicious both for the end of this year and for next year.

When you look at the rest of Warner's, which is not just film, and New Line too, but also television at Warner's, really the advantage that Warner's and our diversified film business between Warner's and New Line has is we are the largest and most consistently successful earnings and cash flow producer in the film and TV studio business. We have had that every year for the last five or six years. We've got pretty big and diverse slates both in film and television.

On the film side, I think it has been well covered that we have an ongoing flow of more big event films than other competitors have. And in television, that is essentially true as well because we are selling two, three, four series to everyone of the five broadcast networks, which I don't believe anyone else is doing. So we do have next year in TV, six shows coming off network syndication. Four of them are already sold. They include Two and a Half Men, Cold Case, Georgia Lopez, One Tree Hill, The OC and What I Like About You. So we're looking very good and quite happy about how '07 is shaping up.

The same thing for New Line, which has a good slate lined up. It is going to perform well this year, and it is going to do well next year we think. You can never completely predict. Witness Poseidon -- every once in a while one of your ships sinks.

Operator

Your next question comes from Vijay Jayant - Lehman Brothers.

Vijay Jayant - Lehman Brothers

Most of my questions are answered. I just wanted to make the observation on your presentation on the cable historical systems. Those exclude now the Houston and the systems transferred to Comcast, so even that comparison to the old Time Warner is not apples-to-apples. So I think the net add numbers that seem a little light arguably are not as light as it sort of looks visually. Is that a fair comment?

Jeff Bewkes

Yes.

Wayne Pace

Yes, actually the trending schedules are now available online. We show that recast exactly so that you can see in the historical Time Warner Cable systems the change is off the lower base over the periods covered in the trending schedules.

Jeff Bewkes

The analysis I think is going to be published, so the rest of you could include it in your own models.

Operator

Your next question comes from Richard Greenfield - Pail Research.

Richard Greenfield - Pail Research

A question on cable. When you look at the Time Warner Cable S1, they actually broke out pro forma Q2, as well as pro forma fourth quarter for last year. I believe just as everything is represented now for the Q3 numbers are the ending subscriber numbers that you showed now. I wondered if you could just talk to the deceleration because I don't know the Q1 and Q2 breakout, -- but certainly a deceleration in Q3, including the Adelphia systems in terms of both basic digital and data? It decelerated, you actually added basic subs on average throughout the entire system for the first two quarters of the year, and you had digital subscribers of like 200,000 plus adds in the first half and 300,000 plus data adds.

So just understanding what happened, including Adelphia? Why did Adelphia slow down because that seems to be the biggest drag in Q3? That would be great.

Jeff Bewkes

Precisely because we have this sort of S1 out there, the lawyers have schooled us all that there is only so much we can say at this point in time. So I'm going to ask our lawyer who is sitting here. How do you want us to step up to Rich's question? I don't know that we can wander into that minefield.

Unidentified Corporate Representative

There is historical data, but I would not give them a lot of specific projections about what you see happening in the future.

Unidentified Corporate Representative

I think the other thing to keep in mind is that with pro forma information it is precisely that with respect to the historical, it is based on systems that are not operated on a combined basis. It is always very clear that pro forma historical information may not reflect what future performance would be. You take that all into mind and do take a look at the documents, but the pro forma themselves are inherently limited in what the information they can provide.

Richard Greenfield - Pail Research

But it would be fair to say that page 10 of the S1 that breaks out subscribers, all of those metrics for Q4 '05 and Q2 '06 are on the same exact basis as you reported this quarter's end of Q3 subscriber numbers?

Wayne Pace

Rich, as best as we can ascertain it, because remember we did not run these systems. They were not under our financial reporting and our control. So if you want [inaudible].

Richard Greenfield - Pail Research

Just one quick follow-up. You spoke to a 15% revenue growth in historical systems, but you did not speak to an EBITDA growth in historical. Could you give us some sense of that?

Wayne Pace

You can’t see it in the room, but our legal team is looking at us and shaking their heads. The difficulty, Rich, and we will work through the difference in margins and stuff as best we can in the realm of what is appropriate offline and talk to you about the drivers that are readily available to you in the financial reporting. But it becomes much more difficult to separate what is affecting the acquired systems versus the historical TWC systems once you get below revenue and you get away from the actual subscriber numbers.

Because, let's put it this way, most of the systems they are acquiring are fitting into existing clusters. So it becomes an allocation question of where do the integration costs go when you conform billing systems and things like that. There's a lot of judgment in that, and I don't think under the S1 process we feel comfortable doing that.

Richard Greenfield - Pail Research

Thanks.

Operator

Your final question comes from Gordon Hodge - Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Great, thanks. Just a question on AOL Europe, the Europe transaction. Just how should we think about the ad revenue opportunity there? Should we think of you more as an agent in the Ad.com role as you take over ad sales there with your partners, or is it perhaps a more generous kind of split arrangement?

Lastly also, if you could comment, Jeff, a little bit about the DVD marketplace, what you see out there? I think units and sales were down a little bit, but any anything to discern from that?

Dick Parsons

I think Jeff will deal with the DVD part. I think the answer is the latter in your formulation of a more generous split arrangement where essentially AOL will continue to be either the lead page for the customers we are sending into the new access provider or as a default page for other customers of the access provider, and there will be a split arrangement on the advertising revenues generated, which we are very pleased with the split. So I will put it that way.

Jeff Bewkes

On DVD, we all know that the growth rate has slowed, but the category is still robust in terms of revenues and profits. I think it is important to remember that the DVD player has had the fastest consumer adoption of I think any consumer electronic device. So the current market status is consumer spending on home entertainment, rentals and purchases for the first nine months of this year '06 was up slightly 1% we think to about $14.7 billion. That is coming from video business research. Sales of all formats, if you took DVD, VHS, PlayStation and high def were pretty much flat at around $9 billion, $9.1 billion through September. DVD sales were up 2%, and the rental market was up almost 2% to $5.6 billion to $5.7 billion.

So it has slowed down from the old days, but in that market, even in this year's theatrical lineup, Warner Home Video representing Warner, some of New Line, some of HBO, is the number one share seller at 19% of the market. So that is the market stat, that is our position in the market. We think it will come up as the rest of the year unfolds.

James Burtson

Thanks, Gordon. Everyone on the call, thanks so much for your time. We will see you next time.

Dick Parsons

Or at least talk to you. Be good. Bye.

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Source: Time Warner Q3 2006 Earnings Call Transcript
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